Definition of Federal Funds
Federal Funds: Excess reserves that commercial banks hold beyond the reserve requirement set by the central bank. These funds can be lent to other banks and market participants in need of liquidity, often for very short periods, typically overnight. The interest rate for these loans is known as the federal funds rate, which is a critical tool for monetary policy.
Federal Funds Rate vs. LIBOR Rate
| Federal Funds Rate | LIBOR Rate |
|---|---|
| Set by the Federal Reserve | Set by a group of banks (15 major banks in London) |
| Reflects the cost of overnight borrowing amongst U.S. banks | Reflects the cost of borrowing across multiple currencies and maturities |
| Primarily plays a role in U.S. monetary policy | Offers a benchmark for various financial products globally |
| Typically lower than LIBOR | Often higher due to credit risk premiums |
Examples and Related Terms
Example: If Bank A has excess reserves of $10 million and Bank B needs $10 million to meet its reserve requirement, Bank A can lend to Bank B at the current federal funds rate, say 1.5%. After one day, Bank B repays the $10 million plus interest, giving Bank A a small profit.
Related Terms:
- Excess Reserves: Amounts held in reserve by banks over the required minimums, available for lending.
- Reserve Requirement: The minimum amount of reserves a bank must hold against deposits, established by the central bank.
- Monetary Policy: Actions taken by the central bank to influence the money supply and interest rates.
Illustrative Concept Diagram
flowchart TD
A[Commercial Banks] -->|Excess Reserves| B{Available Funds}
B -->|Lend Overnight| C[Other Banks]
C -->|Pay Back Principal + Interest| D[Bank A Profit]
style A fill:#f9f,stroke:#333,stroke-width:2px
style B fill:#bbf,stroke:#333,stroke-width:2px
style C fill:#ffb,stroke:#333,stroke-width:2px
style D fill:#aff,stroke:#333,stroke-width:2px
Humorous Quotes, Facts, and Insights
-
Quote: “The Federal Reserve and the banks share a bond, like overly attached friends. When one is broke, the other is always ready to lend, just don’t ask about interest!”
-
Fact: Did you know that the choice of “overnight” for these loans signifies just how desperate banks can be for cash? It’s like them crying out, “I’ll pay you back by morning!” 🥱
-
Insight: The Federal Funds Rate often looks like a teenager borrowing money for pizza: at first, it seems low, but when you add toppings (interest), it can add up quickly!
Frequently Asked Questions
-
Why do banks lend federal funds to each other? Banks lend to manage liquidity. If banks have excess reserves, they want to earn interest instead of leaving it idle.
-
How does the Federal Reserve influence the federal funds rate? The Fed can influence this rate through open market operations, modifying reserve requirements, or changing the discount rate.
-
What happens if the federal funds rate goes up? An increase typically leads to higher borrowing costs, which can slow down consumer spending and investment, a classic case of “borrowing blues.”
Further Learning Resources
- Federal Reserve - Federal Funds Rate
- The Federal Reserve and the Financial Crisis by Ben S. Bernanke
- How the Economic Machine Works by Ray Dalio
Test Your Knowledge: Federal Funds Edition Quiz!
Thank you for exploring the world of Federal Funds with us! Just remember, finance has its own kind of humor; it usually involves someone counting their money while keeping an eye on the interest! 📈💰
